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Booming stock market puts spotlight on zeroed-out GRATs

January 17, 2014

Grantor retained annuity trusts, or GRATs, have been used by high wealth individuals to save transfer tax. In some cases, individuals have been able to structure GRATs in such a way that substantial amounts of wealth can be transferred to family members at zero estate or gift tax cost. This may be especially true for those who set up GRATs in the past few years and were or will be able to gain maximum advantage of the spectacular stock market returns in 2013. A provision in the President’s Fiscal Year 2014 Budget would crack down on such zeroed-out GRATs and other perceived abuses with GRATs. While this provision has been included each year in the President’s annual tax proposals, it may get a closer look in light of how the market’s recent performance has enhanced the use of GRATs as a transfer tax avoidance tool.

Background. A GRAT is a type of trust that individuals use primarily to transfer future appreciation while saving on transfer taxes. An individual transfers property to the trust and retains an annuity interest in the trust for a specified term, and at the end of that term, the property goes to a child or other person named at the outset. Gift tax is payable, but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. A GRAT that is structured so that the present value of the individual’s annuity equals virtually 100% of what the individual put into the trust, such that the gift is essentially eliminated, is referred to as a “zeroed-out GRAT.” However, under Code Sec. 2702, if the retained annuity interest is not a “qualified interest” that satisfies certain requirements, then no value is assigned to it and gift tax is payable on the entire value of the property transferred to the trust.

The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this is so only if the grantor survives the trust term. If the grantor dies during the trust term, the trust property will be included in his gross estate under Code Sec. 2036.

RIA observation: An individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not done the transaction, except that he will have incurred costs of setting up and administering the trust.
RIA observation: The low interest rates that currently apply in valuing annuities, life estates, etc. (2.2% for January 2014) make it a particularly good time to set up a GRAT. That’s because a lower interest rate results in a higher value for the retained annuity than would a higher rate. As a result, the value of the gift of the remainder is lower than it would be if interest rates were higher.

Perceived abuses. A Treasury explanation of the President’s Fiscal Year 2014 Budget (see Weekly Alert ¶  8  04/18/2013) affecting GRATs notes that “[t]axpayers have become adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor’s death during the term), in many cases to two years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.”

RIA illustration An individual transfers substantial funds to a GRAT that, by its terms, will last for two years. The GRAT’s terms require it to make large enough payments to the individual (or to his estate if he dies before the end of the trust term) so that the value of the property transferred to the GRAT equals the value of his retained interest. As a result, no gift tax is due on the transfer to the GRAT. The GRAT, in turn, invests in stock that appreciates in value far more than the interest rate assumed under the Code Sec. 7520 tables at the time of the initial transfer. This excess growth passes to the individual’s children at the end of the two-year trust term at no estate or gift tax cost to the individual.
RIA observation: The savings can be magnified by setting up multiple GRATs, as many wealthy individuals reportedly have done.

President’s proposal. Each year, the President’s annual tax proposal has included a provision that would curb perceived abuses with GRATs. The proposal would require that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. The proposal also would include a requirement that the remainder interest have a value greater than zero at the time the interest is created and would prohibit any decrease in the annuity during the GRAT term. As the Treasury’s explanation of this proposal notes, a minimum term would not prevent “zeroing out” the gift tax value of the remainder interest, but it would increase the risk that the grantor would fail to outlive the GRAT term and thus lose the anticipated transfer tax benefit.

Whether any of these measures will be enacted or even be considered by Congress remains to be seen. In the meantime, the reported widespread use of zeroed-out GRATs is costing the Treasury billions in lost revenue.